Cost Segregation Audit Techniques Guide
This ATG has been developed to assist Internal Revenue Service (Service) examiners in the review and examination of cost segregation studies. The primary goals are to provide examiners with an understanding of why:
1. cost segregation studies are performed for federal income tax purposes;
2. how cost segregation studies are prepared; and,
3. what to look for in the review and examination of these studies.
The ATG was developed by a cross-functional team of Service engineers and agents and is not intended as an official IRS pronouncement. Accordingly, it may not be cited as authority.
In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates in order to properly compute depreciation.
When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to “segregate” or “allocate” costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a “cost segregation study,” “cost segregation analysis,” or “cost allocation study.”
In recent years, increasing numbers of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions. The issues for Service examiners are the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components.
The most common situation is the allocation or reallocation of building costs to tangible personal property. A building, termed “section (§) 1250 property”, is generally 39-year property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed “section (§) 1245 property”, are tangible personal property. Tangible personal property has a short recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance). Thus, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to § 1245 property, or by reallocating § 1250 property costs to § 1245 property.
A simple example illustrates the tax benefits of a cost segregation study. In general, a turnkey construction project includes elements of tangible personal property (e.g., phone system, computer system, process piping, storage tanks). It is relatively easy to identify these items as §1245 property and allocate a portion of the total project costs to them. However, a cost segregation study may also report certain building occupancy items, such as carpeting, wall coverings, partitions, millwork, lighting fixtures, suspended ceilings, doors, as §1245 property. These items may or may not constitute qualifying §1245 property depending on particular facts and circumstances, such as the location of the assets and the specific activities for which the project was designed.
In addition to identifying specific project components that qualify as §1245 property, cost segregation studies may treat portions of building components as §1245 property. For example, a study may conclude that 15 percent of a building’s electrical system directly supports §1245 property, such as specialized kitchen equipment. Based on that conclusion, the study will then treat 15 percent of the electrical system as §1245 property. The allocation of building components to §1245 property is often a contentious issue.
Property allocations and reallocations are typically based on criteria established under the Investment Tax Credit (ITC). A plethora of legislative acts, court decisions and Service rulings have produced complex and often conflicting guidance with respect to property qualifying for ITC, resulting in no bright-line tests for distinguishing §1245 property from §1250 property. Related issues, such as the capitalization of interest and production costs under IRC §263A and changes in accounting method, add to the complexity of this issue.
In a recent landmark decision, the Tax Court ruled that, to the extent tangible personal property is included in an acquisition or in overall costs, it should be treated as such for depreciation purposes. The court also decided that the rules for determining whether property qualifies as tangible personal property for purposes of ITC (under pre-1981 tax law) are also applicable to determining depreciation under current law. [See Hospital Corporation of America, 109 T.C. 21 (1997)] The Service acquiesced to the use of ITC rules for distinguishing §1245 property from § 1250 property.
Based on these developments, the use of cost segregation studies will likely continue to increase. Unfortunately, there are no standards regarding the preparation of these studies. Accordingly, studies vary widely in terms of the methodology, documentation, depth, format, and expertise of the study’s preparer. This lack of consistency, coupled with the complexity of the law in this area, often results in an examination that is controversial and burdensome for all parties.
Examiners reviewing cost segregation studies must determine the proper classification and correct costs of property. In some cases (e.g., small projects) examiners may be able to evaluate a study without assistance. However, other studies may require specialists with expertise, industry experience and specialized training (e.g., Engineers, Computer Audit Specialists and/or Technical Advisors). Examiners should perform a risk analysis as early as possible to determine the depth of an exam and the need for assistance.
Summary and Conclusions
Depreciation issues involving cost segregation studies cross all LMSB industry lines and impact SB/SE taxpayers as well. The lack of consistency in cost segregation studies and the absence of bright-line tests for distinguishing property contribute to the difficulties of this issue. The purpose of this ATG is to provide the foundation to a better understanding of cost segregation studies and to provide the examination steps that will facilitate the audit process and minimize burden on taxpayers, practitioners and Service examiners alike.